They're All Too Big to Fail

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"It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these [credit default swap] transactions."
-- AIG financial products head Joseph Cassano, August 2007

Lesson learned: Wall Street disastrously overestimated its intelligence when it comes to the obscurity of derivatives. George Soros's warning that "we don't really understand how [derivatives] work" wasn't meant jokingly.

And don't fool yourself: Just because AIG (NYSE: AIG  ) gets to backstop its derivative losses with a blank check from Uncle Sam doesn't mean this nightmare is over. Plenty of Wall Street banks -- all of them "too big to fail" -- are ticking time bombs when it comes to bloated derivative books. Have a look:


Total Assets

Notional Value of Derivative Contracts

JPMorgan Chase (NYSE: JPM  )

$2.2 trillion

$87.4 trillion

Bank of America (NYSE: BAC  )

$1.8 trillion

$38.3 trillion

Citigroup (NYSE: C  )

$1.9 trillion

$31.9 trillion

Goldman Sachs (NYSE: GS  )

$884 billion

$30.2 trillion

Wells Fargo (NYSE: WFC  )

$1.3 trillion

$1.5 trillion

Bank of New York Mellon (NYSE: BK  )

$237 billion

$1.1 trillion

Sources: Yahoo! Finance and Office of the Comptroller of the Currency.

To put this in perspective, AIG nearly blew up the universe with derivatives notionally worth about $2.7 trillion -- a fraction of some of our largest banks. With that in mind, ask yourself what happens when:

  • Debt markets go completely haywire again, dislocating credit markets.
  • Losses and writedowns push a major bank with trillions of dollars of derivative exposure to insolvency.

Now maybe we can grasp why the Treasury has been adamant on keeping failing giants alive at any cost. The failure of any of our largest banks could conceivably set off an explosion magnitudes larger than the AIG mess. And since many of these are commercial banks with deposits guaranteed by the FDIC, the Treasury and Federal Reserve have a tremendous incentive to make sure failures don't occur -- this is where the celebrated chant of "too big to fail" comes in. 

Too big to fail, too ignorant to think
Accordingly, you'd think we'd be taking steps to dramatically reduce commercial banks' derivative exposure, right?

Wrong. Here's how the Office of the Comptroller of the Currency opened its latest quarterly derivatives report:

The notional value of derivatives held by U.S. commercial banks increased $24.5 trillion in the fourth quarter, or 14%, to $200.4 trillion, due to the migration of investment bank derivatives business into the commercial banking system.

Ah, yes -- that's right. Bank of America bought Merrill Lynch -- a deal tantamount to buying Chernobyl -- for $50 billion. Before that, JPMorgan Chase bought Bear Stearns and Washington Mutual. Wells Fargo bought Wachovia, too. At a time when investors and politicians are cautioning over the peril of "too big to fail," banks are getting bigger and more complicated than ever before, all as one-fifth of a quadrillion (with a q!) worth of notional derivatives saturate their books.

Now, every bank boss will tell you they've got a handle on their derivatives, of course. Risk is contained. They've got this stuff down pat. They understand risk better than anyone else. As JPMorgan Chase CEO Jamie Dimon recently wrote, "[JPMorgan] manages [derivative] exposures name by name -- like a hawk."

That's reassuring, but one has to wonder how anyone can manage something that's notionally worth more than $87 trillion like a blind ostrich, let alone a hawk.

Rene Stulz in The Wall Street Journal recently took it a layer deeper and touted the glorious benefits of derivatives, writing:

That derivatives benefit our financial system and our national economy is well established. Twenty-nine of the 30 companies that make up the Dow Jones Industrial Average use derivatives.

Also, five of the 30 Dow stocks have been bailed out by the federal government due to exploding balance sheets. Almost anything can be abused and exploited to a fatal level. Just sayin'.

In all likelihood -- and as has been proven over the past year -- banks' chief risk-management tool on decatrillion-dollar derivatives is a combination of hope, optimism, and an unyielding faith in Uncle Sam's pledge to backstop anyone who's too big to fail. That should scare you.

Is there a solution?
I'm a strong supporter of saving systemically significant financial institutions from collapse, but it's insanity to continue to allow -- and even entice -- banks to become larger and even more systemically significant than they've ever been. Protecting the financial system in a manner that truly protects the economy won't take place until:

  • Banks that are too big to fail are unwound into smaller pieces.
  • Mammoth acquisitions of one systemically significant institution to another are prevented. 

Until then, we're putting Band-Aids over cancer, and it won't do a thing to help the economy.

For related Foolishness:

Fool contributor Morgan Housel doesn't own share of any of the companies mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (12) | Recommend This Article (1173)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 08, 2009, at 4:09 PM, mrwizard555 wrote:

    everybody on the planet owes everybody else on the planet one thousand dollars. that's what all the derivatives come to. CDS's then hedge the CDS's then hedge the hedges, and so on. in the last 12 months anybody that sold a CDS is an idiot. pure wagers, not sound financial instruments.

    as for too big to fail. the feds colluded in making some of the financial institutions too big to fail. several of the banks on the list stepped up to the plate to buy banks/institutions that did, or were about to, fail. now they are being villified by the (other) feds and the press.

    if this keeps up, FDIC will have a tough time finding an operator for the first national bank of somewhere. every time they do, it makes another bank bigger, and farther down the road to too big to fail.

  • Report this Comment On April 08, 2009, at 5:01 PM, FinancialFellow wrote:

    I'd like to think that once this financial crisis settles down the powers that be in government take proactive steps to lessen the chances of one of these large institutions failing and taking down the whole financial system with them.

    I agree with the author's recommended solutions to break up megabanks prevent them from reforming. That said, I think we have a long way to go before we are out of the woods with the aforementioned banks and the present financial crisis.

    I'm still tempted to pick up stock of some of the megabanks since they're so cheap, though. I can't see all of them going under and the government has already demonstrated a strong desire to prevent that from happening. Therefore, I suspect if and when they do recover the potential for significant gains if you bought now are great.

    I've been investigating various online brokers to determine the most cost efficient approach to picking up cheap stocks:

  • Report this Comment On April 08, 2009, at 6:16 PM, regulatethem wrote:

    An individual bank should not be allowed to be over $1 trillion in assets. There should be NO derivative contracts. And risk should be kept at a minimal level, heavily regulated by the Feds.

  • Report this Comment On April 08, 2009, at 7:11 PM, maccdw wrote:

    $200 Trillion in notional value? What are amounts of the premiums paid to the issuers? Even if the premium to buy protection via a CDS is a penny on the dollar, that would be $2 Trillion in taxable revenues to banks.

    So......where is the tax revenue?

    By the way, maybe SOMEONE in the Foolish world will actually tell us how expensive CDS premiums are. Maybe premiums are a whole lot more than a penny on the dollar. Just sayin'.

  • Report this Comment On April 08, 2009, at 11:29 PM, nuf2bdangrus wrote:

    From someone who works inside the banking industry...this makes me sick....with big hefty profits for those at the top, and continued cutbacks for those of us who generate the real revenue at the customer level. Bottom line...this crisis isn't fixed until the banks are made so small that a failure would be as significant as the failure of a mom and pop place. i.e. like a pebble in the ocean. The banks, too big to fail, have DC by the nads. And the taxpayers are taking it where the sun doesn't shine. This is socially disturbing and dangerous. Americans have been an apolitical bunch, enjoying our liberties..Should things get worse, the productive middle class might actually awake from their slumber and revolt/demonstrate...after all, we are the class that pays for the rich and poor alike. And the politicians would have to actually listen.

  • Report this Comment On April 09, 2009, at 12:07 AM, BankmenAndRobing wrote:

    It Gets Worse:

    Does a Bank, as a duty of care, inform a customer it has traded a loan in a derivative swap CDO? Try explaining to any Judge at the Superior Court level and above that there does indeed exist a scenario under which a Bank would not want to be paid off.

    See: at

    "The Promise and Perils of Credit Derivatives"

    David A. Skeel Jr.

    University of Pennsylvania Law School

    Frank Partnoy

    University of San Diego - School of Law

    Page 3: "First, a credit default swap is a private contract in which parties bet on debt issuer's BK....."

    Page 17: "....a lender that has purchased default swaps may have the incentive to affirmatively DESTROY VALUE (emphasis included)"

    Pge 21: "However most industry participants doubt that judges will do much..."

    Ever see a financial measurement by a Federal Agency, like the OCC, expressed beyond $ Trillions?

    $ Quintillions?

    Bail Out the Banks? What is the difference between this action and "aiding and abetting"?

  • Report this Comment On April 09, 2009, at 7:00 AM, hikerdude7088 wrote:

    When are we going to wake up and realize that 1. that there is NO such thing as FREE TRADE 2. we are a diminishing empire 3. this is payback by the rest of the world. When people hate you, the way you do cut throat business and your foreign policy; they will make you pay.

  • Report this Comment On April 09, 2009, at 9:27 AM, brwn8484 wrote:

    I'm not sure what is more humerous? Is it the idiots that buy the party line (too big to fail... OOOOOH I'm scared) or the the brain dead that keep shoveling this load of pooh.

    Either way, its more of the same criminal behavior. Just wish people would think for themselves and work together to get rid of all these BOZO's who have run our country into the worst economic mess this world has ever seen. And I'm talking about both parties!!!!! Its our leaders (all of them) including current vermin elect and corporate fatcats. Congress hasnt been able to run their own lunch room at a profit for over 20 years... How are they going to tell us how to get out of this mess? Once the naive and brain dead realize that we all can think for ourselves, maybe we can fix this mess. Until then, I'm preparing for next major depression. If by some miracle, the average joe wakes up and realizes that his bacon is about to fried, we may be able to save ourselves. Otherwise, as they say in the Military, stick your head between your legs and kiss your A** goodbye!!! Been real boys.... See you all at the soup line "Comrade".

    P.S. - Remember one last thing.... All of these crooks in Washington work for US!!!!!! Not the other way around.

  • Report this Comment On April 09, 2009, at 2:46 PM, PoundMutt wrote:

    My head is spinning! I really don't understand much in this article or in the comments. What does all of this mean for a 70 year old retiree on social security and a very small pension, whose working wife makes about $30 K per year?

    Please explain in terms simple enough for a dummy who couldn't become a millionaire because of too little brains (and/or talent.)

    What should we do with our IRAs? Convert them into gold and hide it between the mattress and box spring?

  • Report this Comment On April 14, 2009, at 9:45 PM, rdlincoln wrote:

    I couldn't agree more. If "too big to fail", they're too big and should be broken up. No financial institution should be allowed to become so big that it threatens the world financial system.

  • Report this Comment On April 15, 2009, at 1:13 PM, pedorrero wrote:

    The more disturbing question is: what is the long term consequences of all this political and economic idiocy? Don't you believe that the bottom will come -- sometime, when the dollar becomes worthless and political turmoil ensues? Who will pick up the pieces? Do we return to a smaller, freer government, perhaps with gold as money (again)? Or (sadly, I feel the more likely choice) do we become something like a dictatorship? History is not kind to nations that pursue the course we have been on.

  • Report this Comment On July 14, 2009, at 6:16 PM, 60srad wrote:

    The combination of reckless deregulation and the failure to enforce antitrust laws and of the SEC to monitor the Ponzi market should have been a predictably disastrous combination and would have been, had conservatism not become so fully entrenched as to overrule all logic and reason.

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